Ways to Evaluate and Manage Investment Risks in Emerging Markets

With regions spanning from Asia to Latin America, the emerging market equity universe is broad and can offer a wide array of companies from which to choose across sectors.  At Aberdeen Asset Management, we speak frequently with advisors and investors about how we evaluate risks relating to investing in emerging markets.

We’ve found that many advisors and investors consider both investment risk and operational risk.  The one that seems to get the most attention is investment risk, which is interpreted as volatility of returns relative to an index.  As a result, investors are frequently concerned when a portfolio looks significantly different from the index in terms of country, sector or stock weights. 

However, we recommend that advisors and investors should not be too concerned about investment risk when an investment manager follows an active-managed emerging market strategy focusing on quality because:

• The largest companies in an index may not necessarily be those with the highest quality, and therefore may not have a prominent position in an active manager’s portfolio.
• In emerging markets (which are relatively illiquid compared to their developed counterparts), share price volatility can be driven by short-term flows and may be separated from corporate fundamentals.
• Active management typically leads to a concentrated portfolio and therefore less diversification at the portfolio level. This allows investment firms time to focus on corporate engagement to either protect or improve investments.

When examining an actively managed equity portfolio, such as the Aberdeen Emerging Markets Fund, risk should be viewed on a number of different levels. Two major types of risk that investors should consider are:

• Stock risk – It is crucial that investors know and understand the companies they’re investing with, and that there is a well-established and rigorously applied process to manage this risk. Along with staying up-to-date on company news and visiting a company periodically, we believe that investors should vote in all shareholder meetings and regularly engage with companies’ directors and management.
• Portfolio risk – Investors must make sure that they understand their portfolio positioning and that the portfolio aligns with the stated investment philosophy. For example, if an investment philosophy is focused first on quality, this should be reflected by companies’ return-on-equity and debt-to-equity ratios.

Please remember that to do better than an index, you have to be different from the index. Overweights or underweights relative to the benchmark can be a key ingredient for potential outperformance.

What is your risk appetite?

Just as risks are not created exactly equal, neither are investors’ risk appetites. At Aberdeen, we understand that risks run deep and, consequently, we embed risk management across our investment philosophy.

We take risks seriously—it’s easier to build safety nets before they’re actually needed.

Having a solid understanding of the risks frequently associated with an allocation to emerging markets allows advisors and investors to put appropriate controls in place in order to guard against the potential for loss of principal.